Real estate investors enter the real estate investing business for the sole purpose of making money and returns from their investment properties. Before making an investment decision, however, real estate investors need to know how much the investment will return. The average return on investment is one of the many ways of measuring an investment’s profitability.
The simple way for measuring the rate of return on investment is by taking the gain from the investment, subtract the cost of investment, and divide the sum by the cost of investment. For example, if you invested a total of $50,000 into a real estate investment property, and the total gain you made from your investment sums up to $70,000, then your ROI would be ($70,000 – $50,000)/$50,000 = 0.4 = 40%. Measuring the average return on investment, however, requires a different formula.
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What Is the Average Return on Investment?
The definition of the average return on investment is quite straightforward. It is the income generated from the real estate investment property, as a percentage, in relation to its initial cost.
What Is a Good Average Return on Investment?
Real estate investment property values, interest rates, and economic changes make it impossible to calculate a universal good average rate of return.
As the real estate market changes, so does what is considered a good average return. In general, a good average return on investment would indicate that the return has surpassed the average rate of return in the real estate market. Some real estate investors would be satisfied with a return that meets or merely exceeds the average return. However, other real estate investors would seek a return that greatly exceeds the average real estate investment return. Thus, the answer to the question “What is a good average rate of return on investment?” is relative.
Additionally, the scale of a good average return on investment can greatly change based on economic conditions. An average rate of return that is considered good in one era may no longer be so in another. Market conditions change, and old standards give way to new; what was once “good” could now be considered below average. To succeed in the real estate market, it is important that your real estate investments at least keep up with the changes that occur within the market.
Moreover, it is necessary for a real estate investor to determine an average rate of return that is not only “good” but also realistic. Real estate investors who are expecting 10% or more per year may be setting themselves up for disappointment. Therefore, it is recommended to conduct real estate market analysis to get a general idea of what return on investment you should expect from your real estate investment property.
Related: Using Mashvisor’s Investment Property Calculator to Estimate Rate of Return
A “good” average return on investment for a real estate investor ultimately depends on his/her own financial goals.
Why Does Average Return on Investment Matter?
Based on the real estate investor’s personal investment goals and aspirations, it is important to know the average return on investment that is expected from a real estate investment property in order to be aware of good or even above-average investment opportunities. In order to succeed in the real estate investing market, you, as a real estate investor, have to be able to know what a good average rate of return currently is. After all, you may be investing your money to accomplish specific objectives and personal goals such as securing your child’s college education or your retirement, and you can’t afford to lose money or make less than the average return on investment.
Average Return on Investment Calculation
To calculate the average return on investment, we take the total cash inflow over the life of the investment and divide it by the number of years in the life of the investment. The difference between the simple rate of return calculation and an average return on investment calculation is that the latter does not guarantee that the cash inflows are the same in a given year, which is what simple rate of return calculation assumes.
To calculate the average return on investment, real estate investors take the total profit during the life of the investment, divide it by the total number of years the investment was held, then divide that sum by the initial amount invested (purchase cost), and multiply the final sum by 100. Thus, the average return on investment calculation would look like this:
(Total Profit during Investment Life/Number of Years of Investment)/Initial Amount Invested x 100
Example of Average Return on Investment Calculation
Let’s assume a real estate investor purchased an $800,000 real estate investment property and plans to hold it for 4 years. After deducting all operating expenses, real estate taxes, and property insurance, the real estate investor receives $65,000 in year one, $71,000 in year two, $69,000 in year three, and $70,000 in year four.
The total profit (or cash inflow) during the life of the investment is: $65,000 + $71,000 + $69,000 + $70,000 = $275,000
Now, we divide this number by 4 (the number of years in the holding period) to reach $68,750 as an average annual return. Lastly, we divide $68,750 by the initial $800,000 invested (purchase price) and multiply the sub by 100 to calculate the average return on investment, which in this example is 8.59%.
Related: Using Mashvisor’s Investment Property Calculator to Estimate Rate of Return
As we’ve mentioned earlier, the average return on investment does not take into account the time value of money, which is a drawback. This means that the $65,000 received in the first year was more valuable than the $70,000 received in the fourth year because the $65,000 had been invested to earn more money.
The Bottom Line
Before making any future investment decisions, any real estate investor should always conduct real estate market analysis to determine what average return on investment he/she should expect. Using the average return on investment calculation is pretty straightforward and very helpful as it leads to making smart decisions in the real estate market.
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As mentioned, the rate of return on investment is an important measure in real estate. One thing that real estate investors need to always bare in mind is the negative return on investment. Read this guide to familiarize yourself with this concept and discover ways to avoid it.